Fed Watchers Join QE Debate With Scathing Words

As debate rages about whether the Federal Reserve’s aggressive asset-buying policy will revive a frail economy, some prominent central bank watchers have made it clear just where they stand on the subject.

The Federal Reserve headquarters in Washington, DC.

“The Fed will write $1 trillion or more in checks over the next twelve months, the ECB will write the same,” Bill Gross, the founder and co-chief investment officer of Pimco, the world’s biggest bond funds, wrote via Twitter late on Sunday. “(There is) reflation ahead. (It) will create asset bubbles but little growth.”

That view appeared to be shared by Martin Feldstein, a former chairman of the Council of Economic Advisers which advises the U.S. president on economic policy, who had critical words for the Fed when he wrote an opinion piece in Friday’s Financial Times newspaper.

Feldstein, an economics professor at Harvard University, said the Fed’s decision to buy mortgage-backed assets for an unlimited time means the central bank has now embarked on a “very dangerous strategy” that could lead to high inflation and destabilizing asset bubbles.

The Fed said last month it would create money so it could buy $40 billion worth of mortgage-backed securities a month, a policy it intends to pursue until the jobless rate, currently at 8.1 percent, falls significantly.

But by focusing on unemployment, the Fed has put itself in a difficult position if the jobless rate stays high and the central bank needs to tighten monetary policy to keep inflation in check, Feldstein wrote.

The Fed is not the only major central bank turning to asset purchases to stimulate economies that have been dealt a severe blow by the global financial crisis. The Bank of Japanlast month said it would boost asset purchases, while the European Central Bank is expected to increase the amount of riskier bonds it has on its balance sheet, through its recently announced Outright Monetary Transactions program.

The latest comments from Gross follow a scathing tweet last month, where the high-profile bond investor referred to central banks as the place where “bad bonds go to die.”

Feldstein said that the Fed’s plan to maintain a loose monetary policy stance until at least mid- 2015 implies almost $1.5 trillion of increased bank liquidity. He is skeptical that the policy to buy mortgage assets will strengthen the economic recovery.

“Mortgage rates are at record lows and home salesare already up sharply. Other potential homebuyers are blocked by tough credit standards (that is, by the need for a high credit score) rather than the level of mortgage rates,” Feldstein wrote.

“Lower mortgage rates may spill over to reduce rates on corporate debt but large businesses with enormous cash balances are reluctant to invest and to hire because they fear future tax increases,” he added.

Another negative consequence of the Fed’s policy action, Pimco and Feldstein believe, is stoking asset bubbles.

The idea is that monetary stimulus, which boosts assets such as shares or property, will make households feel wealthier and encourage consumer spending, which in turn will boost the economy.

The danger with this policy, according to Feldstein, is that any further weakness in the economy or a rise in interest rates to normal levels could trigger a sharp fall in stock markets.

The latest round of stimulus certainly appears to have cheered stock market investors. The S&P 500 stock index is up almost 15 percent this year, while the tech-heavy Nasdaq has risen about 19 percent and the Dow Jones industrial average has rallied almost 10 percent.

The Fed's latest policy action has also attracted criticism within central bank circles. The Fed should have waited for clearer signs of weaker economic growth before launching a new asset-buying program, James Bullard, president of the St. Louis Fed, said last month.

Something Better Than Nothing?

For some economists, however, the debate should not be about whether or not the Fed will succeed but what options the central bank has left.

The Fed has left interest rates near zero since 2008 and has conducted two previous rounds of asset purchases or quantitative easing to lower long-term borrowing costs and promote investment and growth. Yet, the U.S. economy, the world’s largest, remains in a fragile state.

Industrial output fell1.2 percent in August, the steepest decline since March 2009, with the manufacturing sector hit by sluggish demand at home and abroad. Meanwhile, fears that that the U.S. Congress could fail to avert a “fiscal cliff” – the $500 billion or so of expiring tax cuts and spending reductions that kick in in January – have left firms with little incentive to boost production.

“In general, if you don’t like what the Fed is doing, then you have to come up with an alternative plan,” said Richard Jerram, chief economist at Bank of Singapore. “It seems that they (the critics of Fed policy) are fairly short of alternatives at the moment.”

Jerram added that it was better that the Fed took some policy action, rather than stand idle while concerns about the economic outlook grew.

“I would prefer they did something rather than nothing and an asset bubble may be a small price to pay for that,” said Nizam Idris, managing director, head of strategy for fixed income and currencies at Macquarie Bank in Singapore.

Idris pointed out that while the Fed has a dual mandate to keep inflation in check and unemployment low, it has another role which is sometimes over looked: maintaining confidence in financial markets.

“Because of this need to maintain confidence in markets that the Fed is doing something, I think QE is justified even though we still do not know whether it will be successful,” he said.